Interest Rate Hiking & 60/40 Portfolio Pain - Are Balanced Portfolios Dead?
It might have seemed a bit odd at the time but we held off talking about the Federal Reserve meeting last week for two reasons:
We felt the policy changes was largely "priced in." The US central bankers had telegraphed what they were going to do and there was little chance of a surprise.
We have talked A LOT about inflation, monetary policy, interest rates and the like. It was time for a break.
We did want to discuss the outcome of the meeting because the path and approach of the Fed's Open Markets Committee will continue to determine a lot, for Wall Street and for Main Street.
In his live press conference, Jay Powell did go some way to further acknowledging, finally, the state of the economy he is charged with overseeing:
In a rare occurrence and speaking "directly to the American people" The Fed Chair stated that:
"Inflation is much too high, and we understand the hardship it is causing, and we're moving expeditiously to bring it back down"
This is great though it was noticeable to us that Chair Powell said nothing about why the Federal Reserve got it so wrong.
And the fact that they got it wrong is important. Not purely to jump all over a hard working government institution but rather to understand how such a collection of hard working bright minds could have made such a mistake
Because a mistake this was and the consequences are far more severe than perhaps is realized or certainly acknowledged.
One way to understand the very real cost of the Fed's mistake is to recognize the structural change that has occurred in most people's retirement funds over the last few decades and how this new development is now leading to real pain.
For context, there are two broad based approaches to retirement plans:
50 years ago most retirement plans were what is called "defined benefit plans" which meant they paid out a predetermined benefit depending on an array of factors such as length of employment, rank and salary.
These days most plans are "defined contribution plans" which are structured so that employees make a contribution every pay period and their employer often matches a certain percentage.
This has been a tectonic shift in the way Western economies and societies rewards workers and determines a lot both in terms of how the broader financial system operates and how regular people think about their retirement, saving and financial planning.
Many - though not all - defined contribution plans are invested in something called a "Target Date" or "Balanced Portfolio" which consist of a mix of government bonds and stocks to try and reduce volatility.
They have become very popular - especially for the young - who frankly don't have much of a choice.
Typically, a Target Date mix gradually shifts over time: re-allocating slowly from risky stocks to safer bonds as people get older and approach retirement. The shorthand for this strategic approach was often known as the 60/40 Portfolio which involved a portfolio of 60% stocks and 40% bonds.
This portfolio became a sort of shorthand for what the portfolio of moderate investor should be pursuing. An asset allocation that aims to provide - in theory - income, capital appreciation and downside protection.
However:
The problem at present is that stock markets are going down but bond markets are not playing their intended counterweight role.
And not only are they not softening the impact of the present stock market decline but they are actually accelerating the damage.
And here is the outcome. As you can see below, the 60/40 portfolio is having its worst year since 2008 and, unlike then, we are not even in a recession (yet).
The above is the impact of the Fed's current policy of "Quantitative Tightening" - the very opposite of Quantitative Easing.
So, the outcome is an outright disaster. Stocks are down in price. And bonds are down in price (up in yield).
Not great.
And this has been largely the result of the Fed's inflationary mistake. Now regardless of what they would like to do, their hand has been forced and they must raise rates to try and corral the inflationary impulse that is (rapidly) eroding people's purchasing power.
The repercussions and reverberations of this error will be felt for years and could lead to louder calls for reform or even less independence of the US Federal Reserve.
Incidentally, it could also really harm a lot people's faith in the financial system that has sold them Target Date funds and told them to invest in "safe" stock markets.
Jay Powell's Fed is not the only institution struggling at present however. If anything the US central bank is deeply symptomatic of the strains, dislocations and touch choices being forced on people and markets everywhere.
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